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PDF Is There Any Evidence of a Greenspan Put? Swiss National Bank Working Papers 2011-6 Pamela Hall Is there any evidence of a Greenspan put? The views expressed in this paper are those of the author(s) and do not necessarily represent those of the Swiss National Bank. Working Papers describe research in progress. Their aim is to elicit comments and to further debate. Copyright © The Swiss National Bank (SNB) respects all third-party rights, in particular rights relating to works protected by copyright (information or data, wordings and depictions, to the extent that these are of an individual character). SNB publications containing a reference to a copyright (© Swiss National Bank/SNB, Zurich/year, or similar) may, under copyright law, only be used (reproduced, used via the internet, etc.) for non-commercial purposes and provided that the source is mentioned. Their use for commercial purposes is only permitted with the prior express consent of the SNB. General information and data published without reference to a copyright may be used without mentioning the source. To the extent that the information and data clearly derive from outside sources, the users of such information and data are obliged to respect any existing copyrights and to obtain the right of use from the relevant outside source themselves. Limitation of liability The SNB accepts no responsibility for any information it provides. Under no circumstances will it accept any liability for losses or damage which may result from the use of such information. This limitation of liability applies, in particular, to the topicality, accuracy, validity and availability of the information. ISSN 1660-7716 (printed version) ISSN 1660-7724 (online version) © 2011 by Swiss National Bank, Börsenstrasse 15, P.O. Box, CH-8022 Zurich Is there any evidence of a Greenspan put? Pamela Hall∗ April 21, 2011 Abstract Central banks have won in credibility as from the mid-eighties by keeping inflation under control. However, confidence in low inflation might have en- couraged agents to excessive risk-taking, leading asset prices to rise. Moreover, the belief in a Federal Reserve guarantee against a sharp market decline spread across US markets as from the nineties. This belief, commonly referred to as the Greenspan put, raised again the question about the role of asset prices in monetary policy decisions. The problem is addressed by modeling the reaction of the Fed to stock- market deviations from fundamentals over the period stretching from August 1987 to October 2008, which corresponds to the periods where Greenspan until January 2006 and Bernanke from thereon were chairmen. A Taylor rule de- scribing the Fed’s nominal feedback rule to inflation and economic activity on a monthly basis is extended to take account of asset prices. The indicators considered are deflation and volatility in stock prices. Furthermore, a Markov switching process allows to capture contemporaneous as well as forward-looking monetary policy responses to asset prices over the period. We find out that taking asset price deflation improves the Taylor rule fit by some 8%. In periods when the Fed was actively pursuing an expansive or restrictive monetary policy, its reaction to volatility or deflation of financial markets was significant. We also see that the reaction of the Fed to asset prices was greater during financial crises, especially when modeling a forward-looking decision process. Agents’ confidence in a stronger response of the US central bank to significant market declines urging to an easing of monetary conditions in their favour was therefore not unfounded. JEL: C11, C22, E44, E52, E58. Keywords: monetary policy, nominal feedback rule, asset prices, United States. ∗Swiss National Bank, P.O. Box, CH–8022 Zurich, Switzerland. I would like to thank Nicolas Cuche-Curti, Peter Kugler, Sarah Lein, Yvan Lengwiler, Alexander Perruchoud, Angelo Ranaldo as well as an anonymous referee for their valuable feedbacks. The views expressed in this paper are those of the author and do not necessarily represent those of the Swiss National Bank. 1 1 Introduction The subprime credit crisis which hit the world economy in 2007 illustrated once more the workings of integrated financial markets and raised a few major questions about the responsibilities of central banks. The expression Greenspan put had already es- tablished itself in the US markets at the end of the nineties as the belief that the Fed would intervene to guarantee a minimum level of asset prices. The consensus view amongst central bank practitioners is that inflation should be targeted. Excessive inflation in the prices of goods and services is harmful for economies. But just as conventional inflation can distort the allocation of resources, asset price inflation distorts economic behaviour by reducing savings and investments because of an in- flated value of underlying assets. Other important effects of asset prices on the real economy operate through the balance sheet channel for firms or households using asset values when borrowing. Booms and busts in asset prices can therefore be as much a threat to economic stability as conventional inflation. Many argue that asset prices, however, are not to be targeted, because bubbles are difficult to recognise ex ante; and even if it were possible, the macroeconomic consequences of bubbles and crashes are limited as long as central banks keep in- flation under control (Bernanke, Gertler, 2002). Inflation targeting would make it unnecessary for central banks to try to influence asset prices. In the late nineties, the Federal Reserve Bank (Fed) used this framework to explain its decision path not to prick the stock market bubble, but instead waited for it to burst and then cut rates accordingly to cushion the economic consequences. As from 2003, the economic outlook in the US was again in a similar setting. Moreover, a question remains open: if at time of soaring asset prices monetary policy were to be tighter, would this stop a bubble building up? A rise in interest rates would hardly stop agents borrowing to buy an asset expected to appreciate, but would push inflation below target. Other central banks, such as the Bank of England, the European Central Bank (ECB) and the Reserve Banks of Australia and New Zealand, have supported the view that monetary policy should sometimes act to restrain a rapid increase in credit and asset prices. This was for example one of the main justifications for raising in- terest rates in Britain in 2004, while the ECB pointed to the second pillar of its monetary policy strategy, which monitors growth in money supply and credit. The Bank of Japan declares its decision process to follow two directions: the first per- spective is the outlook for economic activity and prices, while the second considers the risks relevant to the conduct of monetary policy. In its annual report published less than one year after the beginning of the credit crunch, the Bank for International Settlements (BIS, 2008) recalls the financial instability hypothesis1 by Minsky. The institution insists on the procyclicality of the financial system and excessive growth rate and thus on the importance of the whole system operation. It believes that the expansion of money and credit has played a key role which is ignored in new Keyne- 1In the eighties, Hyman Minsky recognised that capital economies after a long period of prosper- ity end up in a circle of financial speculation. In brief, the financial instability hypothesis states that over a period of good times, the financial structures of a dynamic capitalist economy endogenously evolve from being robust to being fragile. The Minsky moment is the point when the Ponzi game collapses. 2 sian economic theory where financial markets have no economic consequences in the long run. For this reason, it suggests that monetary policy framework take explicit account of asset price developments and stresses on the need to tighten monetary policy when credit growth soars and asset prices explode, even if this temporarily could reduce inflation to lower levels than targeted. Substitution effects could also take place such that earnings on interest-bearing bonds increase. Additionally to these divergences in views and behaviours, central banks also suffer from a credibility paradox. Their success in controlling inflation as from the mid- eighties have won them credibility; at the same time, confidence in a low inflation might have encouraged agents to excessive risk-taking which led prices in assets such as housing and securities to rise. Financial markets have gained in openness and integration in such a way that crises can spread across markets and continents with unexpected speed. The credit crisis might have unveiled the drawbacks of a hands- off view. If the banking system were insulated from the asset markets, the view that monetary policies should not be influenced by what happens in asset markets would make sense. Asset bubbles and crashes would affect only the non-banking sector; however, the movements in the asset markets did affect the banking sector. Banks were heavily implicated both in the development of the bubble in the housing markets and its subsequent crash. The central banks were also heavily involved ow- ing to the fact that they provide liquidity to the banks during the crisis. In recent years, a significant part of liquidity and credit creation has also occurred outside the banking system. Hedge funds and special conduits have been borrowing short and lending long, and as a result have created credit and liquidity on a massive scale. As long as this liquidity creation was not affecting banks, it was not a source of concern for the central bank. However, banks were implicated and thus, the central bank was implicitly extending its liquidity insurance to institutions outside the regulatory framework. Monetary policy changes have implications for financial markets. In this paper, we will not try to disentangle causality between monetary policy and asset prices, but will constrain the analysis to the reaction of monetary policy to asset markets in the United States over the past two decades.
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